Chapter 14 - Investment Banking, Insurance, and Other Sources of Fee Income CHAPTER 14 INVESTMENT BANKING, INSURANCE, AND OTHER SOURCES OF FEE INCOME Goal of This Chapter: This chapter is designed to explore several of the most important nondeposit financial services banks have offered to the public in recent years, including investment banking, trust services, investments in stocks, bonds and mutual funds, insurance policies, and annuities and examine their possible benefits Key Topics in This Chapter The Ongoing Search for Fee Income Investment Banking Services Mutual Funds and Other Investment Products Trust Services and Insurance Products Benefits of Product-Line Diversification Economies of Scope and Scale Information Flows and Customer Privacy Chapter Outline I II Introduction Sales of Investment Banking Services A Key Investment Banking Services B Linkages between Commercial and Investment Banking C Possible Advantages and Disadvantages of Linking Commercial and Investment Banking D Key Issues for Investment Banks of the Future III Selling Investment Products to Consumers A Mutual Fund Investment Products B Annuity Investment Products C The Track Record for Sales of Investment Products D Risks and Rules for Selling Investment Products IV Trust Services as a Source of Fee Income A History of Trust Services B Roles of Trust Departments C Types of Trusts V Sales of Insurance-Related Products A Types of Insurance Products Sold Today Life Insurance Policies Life Insurance Underwriters Property/Casualty Insurance Policies Property/Casualty Insurance Underwriters B Rules Covering Insurance Sales by Federally Insured Depository Institutions VI The Alleged Benefits of Financial-Services Diversification 14-1 Chapter 14 - Investment Banking, Insurance, and Other Sources of Fee Income A An Example of the Product-Line Diversification Effect Reducing Risk 14-2 Chapter 14 - Investment Banking, Insurance, and Other Sources of Fee Income VII VIII B Potential Economies of Scale and Scope Information Flows within the Financial Firm Summary of the Chapter Concept Checks 14-1 What services are provided by investment banks (IBs)? Who are their principal clients? The primary role of investment bankers is to serve as financial advisers to corporations, governments, and other large institutions Investment banks help underwrite a number of securities for corporations including common and preferred stock, corporate bonds, government and federal agency securities and others In addition, they can provide a number of services including advising clients regarding acquisitions and mergers, creating and trading in derivatives, brokering loan sales, setting up special-purpose entities, stock and bond trading, currency and commodity trading, issuing credit and liquidity enhancements and developing business plans so companies can expand into new markets 14-2 Why were U.S commercial banks forbidden to offer investment banking services for several decades? How did this affect the ability of U.S banks to compete for underwriting business? The Glass-Steagall Act in 1933 prohibited commercial banks from offering investment bank services for primary two reasons One, the bank could force a customer seeking a loan to buy the securities that they were trying to sell as a condition for getting a loan, and second, the bank would be exposed to increased risk due to the volatile and cyclical behavior of investment banking activities Due to this, U.S banks were not able to compete for underwriting business with foreign banking firms who in turn captured U.S customers 14-3 What advantages commercial banks with investment banking affiliates appear to have over competitors that not offer investment banking services? Possible disadvantages? Investment banking services complement traditional lending services allowing commercial banking firms to offer both conventional loans and security underwriting to customers who seek to raise new funds In addition, there are economies of scale in information gathering about clients Though the benefits of cost and risk reduction through this new service dimension have not been proven, the commercial banks have transformed investment banking industry by acquiring some of its largest firms and consolidating smaller investment banks into larger ones However, investment banking services are highly sensitive to fluctuations in the economy and would increase the risk exposure of the commercial bank 14-4 What are investment products? What advantages might they bring to an institution choosing to offer these services? 14-3 Chapter 14 - Investment Banking, Insurance, and Other Sources of Fee Income Investment products include stocks, bonds, mutual funds, annuities, and other nondeposit services The most popular investment products offered by depository institutions include mutual funds The potential advantages of offering these services to customers include generating considerable fee income which may be less sensitive to interest rate movements than traditional services such as loans and deposits In addition, it is possible that it might add prestige and may help position the institution well for the future as more and more individuals start planning for retirement 14-5 What risks investment products pose for the institutions that sell them? How might these risks be minimized? There are several risks involved in the sale of investment products The value of these products is market driven and customers may blame the bank when they not reach their earnings goals Because of their reputation, customers may hold depository institutions to a higher standard than securities brokers for example As a result, they may end up getting involved in costly litigation with customers who are disappointed or who claim that the risks involved were not adequately explained In addition, they may have compliance problems if they not properly register their investment products with the Securities Exchange Commission or fail to follow the rules laid down by regulatory agencies, state commissions, and other legal bodies that monitor this market for the sale of these products Regulators already require these products to be sold in a separate area from where deposits are taken and banks are required to prominently display that these products are not insured by the Federal Deposit Insurance Corporation The customers should also be informed that the investment products are not a deposit or other obligation of a depository institution and not guaranteed by the offering institution In addition, customers must be told that these products are subject to risks, including potential loss of principal Customers must sign a document stating they were informed of these risks The institutions must make sure that the names of these products cannot be confused with their regular products Finally, they must demonstrate that they are regularly monitoring themselves to ensure that their sales personnel are complying with the regulatory requirements and banks are also supposed to be sure that the products they sell meet the needs of each particular customer and situation Compliance with these regulations should help minimize the risks inherent in these products 14-6 What exactly are trust services? Trust departments manage the property of customers including their securities, land, buildings and other investments This is one of the oldest services provided by banks Trust departments should safeguard and prudently manage a customer’s assets to generate earnings 14-7 How trust services generate fee income and often deposits as well for banks and other financial institutions offering this service? Trust departments manage the assets of their customers The financial institution charges their customers a fee for providing these services and generates fee income 14-4 Chapter 14 - Investment Banking, Insurance, and Other Sources of Fee Income Assets managed by the trust departments include deposits and, in some cases, these deposits can be substantial This way, trust departments often generate large deposits because they manage property for their customers It is worth noting that deposits placed in a bank by a trust department must be fully secured 14-8 What types of insurance products banks and a number of their competitors sell today? What advantages could these products offer depository institutions choosing to sell insurance services? Can you see any possible disadvantages? Financial institutions are starting to offer several insurance products One product that they offer today is life insurance in which the bank promises to pay a beneficiary a specific cash payment in the event of the death of the policyholder Another insurance product they are interested in is life insurance underwriting Here, the institution would manage risks associated with paying life insurance claims They want to profit from managing insurable risks and collect more in life insurance premiums than they pay in claims Financial institutions are also getting involved in selling insurance policies for protection from loss due to personal injury, property damage, and other losses associated with property and casualty insurance products In addition, they also underwrite property/casualty insurance risks Again, by doing this, they want to collect more in premiums than they have to pay in claims on these contracts Because of the growth in consolidation of the insurance industry, the financial service providers have been buying out their competitors and emerging as global players Due to this, these companies seek lower production and marketing costs, diversification of risk exposure beyond one or two countries, and opening up greater revenue potential from what they see as “underinsured” markets (especially in Europe and Asia) On the other hand, selling insurance services requires financial institutions to adhere to strict consumer protection rules This is practiced because the public may be misled or misinformed For example, the customer may conclude wrongly that insurance products offered by a depository institution are covered by government-sponsored deposit insurance in case the customer suffers a loss 14-9 What is convergence? Product-line diversification? Economies of scale and scope? Why might they be of considerable importance for banks and other financial-service firms? Convergence is the bringing together firms from different industries in order to create large conglomerates offering multiple services in one place Product-line-diversification suggests that offering services that are not perfectly correlated with each other has the potential to reduce the risk (variability) of the cash flows of the overall company Economies of scale means that there might be cost savings from being able to produce a larger number of units of the same product due to greater efficiency and the spreading of a greater volume of output over the firm’s fixed costs Economies of scope means that there are potential costs savings resulting from producing two or more services in one firm For example, if a single financial firm produces two services, instead of producing only one service, using the same resources, its cost of production may be lower 14-5 Chapter 14 - Investment Banking, Insurance, and Other Sources of Fee Income These things mean that banks and other financial institutions may be more efficient and productive in delivering services to customers either resulting in higher profit margins for companies or cost savings for consumers These strategies can also result in reduced risk of failure through greater product-line and geographic diversification 14-10 How can financial-service customers limit the sharing of their private data by different financial-service firms? In what ways could customer information sharing be useful for financial institutions and for their customers? What possible dangers does information sharing present? Financial-service firms must inform customers of their policy regarding the sharing of information with other parties Financial-service firms must also inform customers about how the customer can opt out of having their information shared with other parties Generally, the customer must inform the company within 30 days of being notified that they not want their information shared If the customer fails to notify the service provider of his or her objections to sharing personal data, then the financial-service firm can share at least some of the customer’s private information with others, even with outsiders This information can be extremely useful to financial institutions because they can use the information to offer more than one service to the customer They have already gathered the relevant information and can target products and services that are particularly a good fit for that customer This can benefit them by increasing profits and cash flows and can benefit the customer by allowing them to get all of their financial services needs taken care of in one place However, there are some real dangers that this information can be misused in some cases For example, if there is some adverse private information about a particular customer (a very serious medical condition) that information might be used to deny them several financial services (such as getting a new mortgage) This customer essentially becomes blacklisted by many financialservices companies Problems and Projects 14-1 Suppose the management of the First National Bank of New York decides that it needs to expand its fee-income-generating services Among the services the bank is considering adding to its service menu are investment banking, the brokering of mutual funds, stocks, bonds and annuities, sales of life and casualty insurance policies, and offering personal and commercial trust services a Based on what you read in this chapter, list as many potential advantages as you can that might come to First National as a result of adding these services to its menu First National may be able to supplement traditional sources of income with the new fee income that they generate and also increase the earnings stability In addition, they may be able to reduce the risk of the overall institution by adding services that are not very correlated with the traditional services They may find that some of these services are less interest rate sensitive than traditional services They may be able to generate economies of scale and scope from offering these services Because of the economies of scale, the production cost per unit would tend to 14-6 Chapter 14 - Investment Banking, Insurance, and Other Sources of Fee Income drop as the firm would get larger Because of the economies of scope, it may become cheaper to jointly produce two or more services than having to produce each service separately b What potential disadvantages might the bank encounter from selling these fee-generating services? There are many potential disadvantages that First National Bank might encounter from selling fee-generating services Investment banking activities tend to be much more volatile than commercial banking activities because of abrupt changes in market conditions and fierce competition These additional services are substantially more risky than commercial banking If First National misestimates and the market price and plunges as the sale begins, it will be forced to absorb the resulting loss Moreover, the value of some such services is market determined and their performance can turn out to be highly disappointing This may anger the customers who may be holding the services being offered by First National to a higher standard of performance than a securities broker First National could also get involved in costly lawsuits filed by disappointed investors who may allege that they were misled about the risks associated with investment products or were charged excessive service fees In addition, First National needs to be sure to comply with all regulations concerning selling investments products Customers could confuse First National’s traditional products with their investment products if First National does not disclose the differences between their traditional products and the new services that they are offering The same thing is true if they offer insurance products c Are there risks to the bank from developing and offering services such as these? If so, can you think of ways to lower the bank’s risk exposure from offering these new services? First National faces the risk of customers not being satisfied with the returns There is also a possibility that such customers may feel they have been misled about these products and sue the bank The bank can prevent some of this by counseling each customer as to the risks involved in these products and have them sign a form stating that they understand the risks involved in these products First National must also be careful to be in full compliance with all regulations These and other regulatory rules must be conspicuously displayed inside offices of depository institutions where investment products are sold Moreover, these products must be sold in an area separate from the area where deposits are taken from the public d What might happen to the size and volatility of revenues, expenses, and profitability from selling fee-based services like those mentioned above? 14-7 Chapter 14 - Investment Banking, Insurance, and Other Sources of Fee Income It is possible that the revenues will rise and expenses will fall, increasing the return to the bank In addition, it is possible that the volatility of the bank’s earnings will decrease It depends, in part, on how correlated the new services are with the old services If they are not correlated, returns can actually rise and volatility can decrease from adding the new services due to the product-line diversification effect 14-2 A commercial bank decides to expand its service menu to include the underwriting of new security offerings (i.e., investment banking) as well as offering traditional lending and deposit services It discovers that the expected return and risk associated with these two sets of service offerings are as follows: Expected return—traditional services Expected return—security underwriting Standard deviation—traditional services Standard deviation—security underwriting Correlation of returns between two services Proportion of revenue—traditional services Proportion of revenue—security underwriting 3.50% 10.75% 2.50% 8.25% +0.25 70.00% 30.00% Please calculate the effects of the new service on the banking company’s overall return and risk as captured by the bank’s standard deviation of returns The banks expected return from the overall service menu is calculated as: E(r) = R TS × E rTS + R NS ×E rNS = 0.70 (3.50 percent) + 0.30 (10.75 percent) = 5.68 percent Where, E(r) = Expected return from the overall service menu R TS = Proportion of revenue from traditional services E rTS = Expected return from traditional services R NS = Proportion of revenue from security underwriting E rNS = Expected return from security underwriting The bank’s standard deviation can be calculated as follows: 2 σ r = R TS × σ TS + R×σ NS + NS2× R TS 1-R = 3.37% 14-8 TS × ρ × σ× σTS TS,NS NS Chapter 14 - Investment Banking, Insurance, and Other Sources of Fee Income Where, σ r = Standard deviation of overall return R TS = Squared proportion of revenue from traditional services σ TS = Variance of revenue from traditional services R 2NS = Squared proportion of revenue from security underwriting σ 2NS = Variance of revenue from security underwriting R TS = Proportion of revenue from traditional services RNS = Proportion of revenue from nontraditional services ρ TS,NS = Correlation of returns between traditional and security underwriting σ TS = Standard deviation of return from traditional services σ NS = Standard deviation of return from security underwriting 14-3 Based on what you learned from reading this chapter and from studies you uncovered on the Web, which of the financial firms listed below are most likely to benefit from economies of scale or scope and which will probably not benefit significantly from these economies based on the information given? a A new bank offering traditional banking services (principally deposits and loans) was chartered earlier this year, gaining $50 million in assets within the first six months This bank should benefit from the increase in size as economies of scale take effect This firm should continue to enjoy economies of scale as it grows in the next several years However, these economies of scale will not continue indefinitely and there is some evidence that economies of scale are exhausted fairly quickly in banking firms The bank could benefit from economies of scope if it has resources that could be used to produce different services b A community bank with about $250 million in assets provides traditional banking services but also operates a small trust department for the convenience of families and small businesses This bank probably does not benefit much from economies of scope It is possible that the bank uses the same resources to provide both traditional banks services and trust services, in which case it could benefit from economies of scope c A financial holding company (FHC) with about $2 billion in assets offers a full range of banking and investment services, giving customers access to a family of mutual funds Economies of scale start to disappear in about this range although there may be some small economies of scale that still exist up until the size of about 10 billion As the bank does provide a range of services, it probably does benefit from economies of scope 14-9 Chapter 14 - Investment Banking, Insurance, and Other Sources of Fee Income d A bank holding company with just over $10 billion in assets also operates a security brokerage subsidiary, trading in stocks and bonds for its customers This firm appears to be outside of the range where any economies of scale exist However, the evidence for economies of scope is clear as the bank provides a wide range of services e A financial holding company (FHC) with $750 billion in assets controls a commercial bank, investment banking house, chain of insurance agency offices, and finance company and supplies commercial and consumer trust services through its recently expanded trust department This firm appears to be outside of the range where any economies of scale or scope exist 14-10 ... information and can target products and services that are particularly a good fit for that customer This can benefit them by increasing profits and cash flows and can benefit the customer by allowing... them several financial services (such as getting a new mortgage) This customer essentially becomes blacklisted by many financialservices companies Problems and Projects 14-1 Suppose the management. .. are trust services? Trust departments manage the property of customers including their securities, land, buildings and other investments This is one of the oldest services provided by banks Trust